Ruling Britannia

The Expectations Game

While the U.S. has trouble clearing the high bar, low market expectations for other major developed economies are helping their stocks outperform. Russ Koesterich and his Investment Strategy Group explain.

Municipal Credit Highlights

America's aging infrastructure is in need of repair, and the municipal market has long been a major source of financing. But state and local governments remain budget constrained. BlackRock muni credit experts discuss this and more in their quarterly credit report.

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The Blog

Mar 26, 2015
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Sara Shores

When you think about a smart beta investment strategy, you probably think about equities. Many investors have become familiar with the notion of capturing historically rewarded factors, such as value, quality, or low volatility, in their stock portfolios. In essence, smart beta strategies seek to re-write index rules to capture these factors. What some investors may not know is that this way of thinking can be applied to bond portfolios. How? Let’s take a look at the market dynamics in fixed income.

Different risk profiles

The first thing to keep in mind is that the nature of fixed income makes the return payout asymmetrical. The best a bond can do is pay its coupons and return its par value; however the worst it can do is default and leave you with $0. As a result a lot of the value that can be generated in fixed income is about loss avoidance, and about managing risk over time.

Equity markets are predominately characterized by stock specific risk. For example, you will likely have a very different return experience investing in Citigroup versus Apple. In contrast, fixed income markets have far less security-specific risk. In fact, the total return for core bond portfolios is governed predominately by exposures to two macro-economic risk factors: interest rate risk and credit risk. As my colleague Matt Tucker wrote in a recent post, core fixed income benchmarks like the Barclays US Aggregate are dominated by interest rate risk, and in the current market environment, investors are not paid very much to take on that risk.

But how should an investor manage these macro-economic exposures in their bond portfolio? The allocation decision between interest rate and credit exposure will have a significantly larger impact on the investment outcome than would any security-specific decisions. BlackRock’s first fixed income smart beta ETF, iShares US Fixed Income Balanced Risk (INC), factors in this dynamic and seeks to generate income through a diversified portfolio that balances the primary components of returns – interest rate and credit risk.

Investor behavior creates opportunity

When it comes to both stocks and bonds, market inefficiencies can be driven by powerful forces like investor behavior and structural impediments. Some of these phenomena are similar across equities and fixed income: many investors are averse to leverage and therefore gravitate to riskier stocks in their search for high returns, which can lead to over-buying of higher volatility stocks.*. That same leverage aversion exists among fixed income investors – longer duration bonds may be over-priced on a risk-adjusted basis compared to similar bonds of a shorter maturity (Barclays). Other inefficiencies are unique to bond markets: commonly used benchmarks like the Barclays Aggregate only include investment grade securities, and as a result some investors add exposure to sectors such as high yield or emerging market debt to help boost yield.

All of the above phenomena are well known by fixed income managers (and have been the fodder of active fixed income strategies for decades) but have not been arbitraged away precisely because of the barriers presented by these behavioral or structural market forces. Fixed income smart beta funds, such as INC, seek to capture these inefficiencies in a rules based and transparent manner.

So what’s next?

With plenty of opportunities for smart beta strategies in fixed income, you may wonder why so few smart beta bond strategies exist. Well, as I predicted in my New Year’s post, this is an area where I expect we’ll see a significant amount of development and innovation in the future. INC is BlackRock’s first important step into that exciting frontier.

Sara Shores is Global Head of Smart Beta for BlackRock. You can read more of her posts here.

Carefully consider the Funds’ investment objectives, risk factors, and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses or, if available, the summary prospectuses which may be obtained by visiting www.iShares.com or www.blackrock.com. Read the prospectus carefully before investing.

Investing involves risk, including possible loss of principal.

The iShares U.S. Fixed Income Balanced Risk ETF is actively managed and does not seek to replicate the performance of a specified index. The Fund may have a higher portfolio turnover than funds that seek to replicate the performance of an index.

Fixed income risks include interest-rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in bond values. Credit risk refers to the possibility that the bond issuer will not be able to make principal and interest payments. Non-investment-grade debt securities (high-yield/junk bonds) may be subject to greater market fluctuations, risk of default or loss of income and principal than higher-rated securities. INC’s use of derivatives may reduce the Fund’s returns and/or increase volatility and subject the Fund to counterparty risk, which is the risk that the other party in the transaction will not fulfill its contractual obligation. The Fund could suffer losses related to its derivative positions because of a possible lack of liquidity in the secondary market and as a result of unanticipated market movements, which losses are potentially unlimited. There can be no assurance that the Fund’s hedging transactions will be effective.

The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective.

The Funds are distributed by BlackRock Investments, LLC (together with its affiliates, “BlackRock”).

According to our latest Investor Pulse Survey, millennial women are managing their finances more frequently than older generations and their investing habits are shifting. 31% of us describe ourselves as active investors while only 15% of our female baby boomer counterparts feel the same way about their own behaviors. We’re also twice as willing to take on higher risk investments to seek higher returns (41% of us versus 22% of female baby boomers).

Even though we’re more willing to take risks than older generations, we still lag our male peers in this department. Men also tend to enjoy managing their investments more than we do (70% versus 36%), which left me to wonder: Why the gap? To learn more about these gender discrepancies, I turned to behavioral finance expert and Blog contributor Nelli Oster.

Q: Nelli, let’s start with the millennial generation as a whole. What are their attitudes in general? And how do they feel about money and investing?

A: A study from Pew Research describes the millennial generation as confident, self-expressive, liberal, upbeat and open to change. Confidence and a flexible attitude are helpful traits when it comes to investing, and it seems more millennials are watching their spending more than they were nearly a decade ago. The Pew study found that 55% are keeping a close eye on their money today versus 43% in 2006. Overall, millennials are very focused on investing and building their savings; 77% worry that they aren’t saving or investing enough.

Q: Now to the gender issue. Why are millennial women more risk averse than millennial men?

A: While millennials as a whole are described as an upbeat demographic, the difference in tolerance for risk between male and female investors transcends generations. One study I found says that it’s not that women are that different from men when it comes to their perception of the size of possible gains and losses, but that they tend to be more pessimistic about the probability of high likelihood gains. A phenomenon known as the risk-as-feelings hypothesis tells us that when emotions conflict with rational assessments, emotions tend to dominate. And women often express feeling nervous more openly, as a result exhibiting more pessimism when faced with risky decisions.

Q: If women are generally more risk averse when they invest, how does this affect them in the long run?

A: Women’s tendency toward higher risk aversion can lead them to be under-invested in risky assets. The danger here is that they miss out on higher returns. But this isn’t all bad: given their generally lower confidence levels, women may have a more realistic picture of their investing skills, be more open to financial advice and research investment decisions more thoroughly before implementing them, relying on well-diversified buy-and-hold investment strategies rather than embarking on the futile exercise of trying to beat the market. This thoughtful approach can benefit women in times of stress. For example, during the financial crisis of 2008-2009, women were less susceptible than men to snap judgments and selling their stocks at market lows. Millennial women who take extra steps to educate themselves have that much longer to invest strategically for the future.

Q: How can women of all ages mitigate their investing biases?

A: My colleague Heather Pelant and I advocate focusing on your long term goals, such as buying a house, retirement etc. To consider: Are you less comfortable taking investment risk because you expect returns in the current market environment to be modest and more volatile than in the past few years? Or are you staying on the sidelines because behavioral biases push you to be nervous? While the former may be justifiable as a near-term strategy, the latter risks derailing you from achieving your long-term financial goals.

Nelli Oster, PhD, is a Director and Investment Strategist at BlackRock.

Ann Hynek is the Global Editor ofThe Blog, writing about investing from a millennial perspective. You can read more of her posts here.